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So, uh...anybody noticed how companies seem to be raising money way faster these days? I’ll admit, I haven’t actually looked at the raw data to confirm this (mostly because I’m too lazy to try to pull that data from Pitchbook), but I’m fairly certain that two things are happening (and here’s a more informed VC perspective on what’s happening):
Hot rounds are happening in split seconds (I’ve heard a number of anecdotes of friends raising highly-competitive seed rounds in under a week, and spoken with VCs detailing rounds happening in under 48 hours).
Companies are raising follow-on rounds extremely quickly. Some really out-there examples are Clubhouse raising at a $1B valuation in January, and just raised at a $4B valuation three months later. Hopin is a similarly crazy story, having raised a seed round at a $40M valuation in February 2020, and has completed three more funding rounds between then and March 2021, and now holds a valuation of $5.6B. In the data space, one example is Dremio, who went from a $400M company in a March 2020 raise to a $1B company after a December 2020 raise.
This more frequent, larger, faster funding makes being an early-stage startup employee doing a job hunt a little bit like trying to catch a falling knife, as would-be employees attempt to join companies as they’re starting to enter hypergrowth, but before the valuation is so high that the company will require years to grow into its valuations. There are lots of stories in the valley these days of startups getting preempted by VCs as they’re thinking about starting to raise funds, and VCs dropping surprise term sheets on those companies. The mechanics of fundraising, and how it impacts employee equity makes this a very tense time for employees that are trying to make job changes.
In the spirit of educating others on how not to get burned, I want to use this post to talk about your option grant paperwork, and focus on two key dates: Grant Date and Vesting Commencement Date. These are both extremely important dates to know about, and to understand the implications of each. The good news is that if you’re thinking about joining a company that is offering RSUs, none of this matters! Get out of here, late-stage startup employee! However, if you’re an early-stager, and you’re getting an ISO or NSO grant, read on, because this shit matters.
What happens when a company gets a term sheet?
In the olden days of 2018, when a company wanted to raise money, they would go talk to investors for weeks, spend hours and hours each day hanging out on Sand Hill Road in Menlo Park, and eventually get a term sheet from a handful of VC firms, and decide who to partner with. The process could take several months, and as a prospective employee, it was helpful to know that a company was starting to fundraise, but no cause for alarm. Just something to keep in mind, if you want to get in before the next round.
The important bit to understand is that as soon as the company receives a term sheet that it intends to sign, the current 409A valuation for the company is invalidated. The 409A valuation is what determines the strike price for newly granted options, so the strike price for an option grant depends on what the 409A valuation is on the day that the grant is approved. When the 409A valuation is invalidated, the strike price for new grants is actually unknown for some time, until the company goes through an auditing process to generate a new 409A valuation. Generally, funding rounds drive the price up, so usually the strike price is going to increase. Once the 409A process is complete, any grants issued during the period after the term sheet was received and accepted will have the new 409A applied as the strike price.
It’s also worth noting that the “intends to sign” bit is an unfortunately fuzzy concept. 409As are determined through an audit process that takes a wide variety of information into account, some of which is subjective. If a term sheet is wholly unsolicited, is isolated and outside of a broader fundraising process, and not accepted, a CFO or VP, Finance could make the argument that this was just an irrational or uninformed investor who doesn’t really know the true value of the stock. Thus, the term sheet should be ignored and not have any impact on the 409A or trigger an invalidation. However, oftentimes multiple term sheets come simultaneously because a company is actually fundraising, and intends to accept a term sheet. In that situation, the first term sheet to arrive is really setting a new valuation on the company that can be corroborated by a series of other term sheets around the same price, and so triggers the invalidation of the 409A.
This graphic illustrates a few of the mechanics at work:
Grant Date versus Vesting Commencement Date
The two key definitions to have in your back pocket are:
Grant Date: This is the date that the Board of Directors approves your grant. This typically happens during a board meeting, and grants are typically approved in bulk for any employees that started in the time since the last board meeting. When particularly important items can’t wait for the next board meeting, boards also have a mechanism called unanimous written consent (UWC) that allows them to circulate a document for signatures (usually via DocuSign or something along those lines these days), which can allow grants to be approved via email. This is the date that determines your strike price.
Vesting Commencement Date: This is the date that your vesting starts, and is typically backdated, when the grant is approved, to your start date. When you have a vesting cliff or other vesting schedule in your employment contract, this date determines when your cliff happens, and on what date in the month your vesting event happens.
In almost all cases, if you look at an option grant contract, your Grant Date will be after your Vesting Commencement Date, because usually the board doesn’t meet the same day that you start, and they’ll just get around to approving your grant whenever is convenient for them. This, however, brings us back to the precarious position that employees end up in around the time of a funding round. Let’s look back at the chart to consider a scenario:
In this situation, an employee signs an offer letter, knowing the current 409A value and strike price, and starts right before a term sheet is signed. However, the board doesn’t meet until after the term sheet is signed, and approves the grant during the period of time while the 409A valuation post-fundraise is still being determined. The employee’s Vesting Commencement Date will be before the 409A valuation was invalidated, but their Grant Date is after the invalidation, and so the strike price they’ll receive on the grant paperwork is actually going to be the higher $4 price, rather than the lower $1 price. Since the employee will have to pay the strike price in order to exercise their options, their options are now a lot less valuable. Specifically, they’ve lost $3 per share of value, due to the increase in strike price.
What the heck? Why can’t the company just give me the current strike?
Before the 409A section of the tax code came into law, a company might have been able to do this (sort of, not really), but post-Enron, companies can’t actually just give you whatever strike price they want. What companies are allowed to do, when you have an offer, is to tell you what the current strike price is, but they can’t promise you a particular strike price. That strike price can only be determined by the 409A valuation, and the company can’t guarantee a 409A valuation on any particular date (though they can likely offer confidence levels that the 409A won’t change before your grant date). This is why you’ll never see a strike price specified in an offer letter. (And if you think you’ve seen this before, you haven’t. Feel free to go check your old offer documents. I’ll wait.)
How can I avoid getting screwed?
The core problem isn’t so much the fact that rounds are happening more often and with faster diligence periods so much as the valuation step-ups between rounds are also skyrocketing. When you have rounds happening months apart, and company valuations rising by 2-5x, it makes it extremely challenging for startup employees to get into companies at the right time, before the equity upside is on the downswing. I suppose, if you can make the argument that the startup market has just been largely undervalued for a long time, maybe these prices are still cheap. It’s hard to feel that way, though.
The way to avoid ending up with a strike price surprise is to make sure that when you’re negotiating your start date for a new job, you ask about specifics around fundraising. It used to be the case that 18 months or so from the last round was the danger zone, but that’s changed significantly in the past several years, as I mentioned at the start of this post. These days, it’s really a best practice to ask early on (and perhaps often if your interview process takes a while):
Does the company expect to kick off a fundraising cycle soon?
How likely is it that an event could invalidate the current 409A before a potential start date?
When do new option grants typically get approved, or how long after starting do grants typically get approved?
It’s not terribly uncommon, these days, for CEOs to ask investors to refrain from sending term sheets until a particular date, precisely to ensure that grants can be approved ahead of a major 409A change. This can be very helpful if you’re trying to figure out what start date would be the best choice, in order to ensure a high probability of getting the strike price you want. It’s also not uncommon, as an employee, to receive guidance ahead of the start of a fundraising cycle, that the 409A may be invalidated in the near future (which is important if you have plans to exercise stock, and want to manage your tax exposure).
It’s also worth remembering that before you’ve signed the offer, you’re still negotiating, and it is perfectly reasonable to work to craft a situation where you get the strike price you want. The company can never give you 100% confidence that you’ll get the strike price you want (I’d be willing to bet any definitive statements fall into a legal gray area), but you can certainly request that they ensure that your grant is approved ASAP after your start date (you need to be officially employed for the grant to be approved, but they can, theoretically, approve it on day 1). The bad news is that grant approvals require board signatures, and asking for special treatment around your grant means the company has to wrangle the board (which might be hard if you’re not a key executive hire). The good news is that if you’re in a situation where there’s a risk of starting on a date after a 409A invalidation, there’s a good chance you’re not the only prospective new hire in that situation, and while one individual contributor might not be a board-level concern, a bunch of them might rise to that level of criticality. It never hurts to ask.
The key in all of this is to arm yourself with knowledge, so that you don’t get taken for a ride. When you’re deciding to accept an offer, especially at a buzzy company, make sure you know when the next fundraising is expected to happen, and if it’s happening soon, ask about when the board will approve grants. Make sure you understand the timelines, so that you don’t end up with a surprise strike price. Good luck out there!